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You may have heard of shares buyback but clueless as to what it does. A shares buyback is for all intents and purposes, the purchase of shares of a company, by the said company. To achieve that, a company repurchases its own shares from, in most cases, the open market.

What are the effects of a shares buyback?

Every company listed on a stock exchange has a certain number of outstanding shares which are in circulation. When a company repurchases its own shares, it does so with the intent of taking those shares out of circulation. That means, shares are purchased and parked in the treasury of the company. When shares are taken out of circulation, there are lesser numbers of outstanding shares. This makes each outstanding shares more valuable.

Fabled fund manager, Peter Lynch, in his book, One up on Wall Street, approves of shares buyback and has this to say:

“When stock is bought in by the company, it is taken out of circulation, therefore shrinking the number of outstanding shares. This can have a magical effect on earnings per share, which in turn has a magical effect on the stock price. If a company buys back half its shares and its overall earnings stay the same, the earnings per share have just doubled. Few companies could get that kind of result by cutting costs or selling more widgets.”

To illustrate, Company X has 100 outstanding shares and made RM10,000.00 in profits, in a particular year. That equates to an earnings per share (EPS) of RM100.00. However, Company X embarked on its shares buyback programme and repurchased 50 outstanding shares. Hence, there are only 50 outstanding shares left and each share is more valuable because each share has an EPS of RM200.00 (instead of an EPS of RM100.00).

Shares buyback and payment of dividend are perceived as fulfilling the same agenda, i.e. rewarding shareholders. Dividend payment disburses a portion of the profit of the company to shareholders, and is tangible. On the other hand, share buyback is rather an intangible reward to shareholders because its aim is to increase the “value” of your shareholding, making it more “valuable”.

As for me, I’d rather have my dividends, unless I can have both.

What are the criteria for shares buyback?

Firstly, for a company to embark on a shares buyback program, it must first have the means to do so i.e. ample cash lying around. This is because cash is obviously required to purchase shares in the open market. This can be interpreted as a good indication that a company has a good cash reserve to buyback its shares unless that means is supported from borrowings (which is never a good thing). Apple recently took advantage of the preferable taxation cuts to repatriate cash which is stored away, from the USA, to buyback $100 billion worth of stocks. Obviously, it has a stockpile of money to burn.

Secondly, it must satisfy itself that it has no immediate use for the cash which may generate more value than shares buyback. For example, if a company had the resources to expand its production or to diversify into another business, where great wealth can be made, it should utilise those resources, as capital for that venture, instead of buying back shares.

Lastly, shares buyback must be done when share prices are reasonable and that the company should never overpay for the shares repurchased. A company may choose to repurchase shares especially when share prices are low – a plan which is adopted/proposed to be adopted by Malakoff, MYEG and George Kent.

On top of shares buyback, Malakoff is also offering a generous dividends, which for me, is a great bonus.

Conclusion

Shares buyback is also a good indication to gauge the performance of a company’s managerial decisions. If shares buyback is initiated at a wrong time or for a wrong purpose, it is very likely that management decisions are impacted for an ulterior or incompetent reason which may be detrimental.

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Ever wonder why does the stock market place an importance on any interest rate adjustment? Today’s write-up will deal with the effects of interest rate on the stock market.

What is interest rate

When a lender lends money to a borrower, the lender expects some form of payment, from the borrower. That form of payment is interest. The rate of interest is therefore the cost of borrowing money.

When interest rate is high, the cost of borrowing would increase, and vice versa.

Importance of interest rate

Interest rate affects every facet of our lives, to the extent that, monetary policymakers and central banks often adjusts interest rate to steer the growth of an economy.

When economic growth is lacklustre, interest rate could be lowered to spur growth. A low interest rate climate encourages consumers, investors and businesses to borrow. The spur of cheap credit would encourage consumers, investors and businesses, big and small, to increase spending on purchases. These purchases may encompass various assets including, real property, commodities and stocks. This inevitably means consumers, investors and businesses will take up more debt, sometimes more than they can afford (unfortunately). For example, consumers would be more inclined to purchase big ticket items, like houses and cars, when interest on the loans are low. This scenario is a normality in Japan where housing loans can be lower than 1% per annum.

On the other hand, higher interest rate would increase the cost of borrowing for consumers, investors and businesses, and would tend to deter people from borrowing and thus spending, because they would not be able to afford a higher cost of borrowing. As a result, economic growth moderates. More often than not, interest rate is increased to prevent an economy from overheating, or to decrease inflation.

Indirect effect

So how does interest rate indirectly affect the stock market? To answer that, you must draw a relationship between interest rate and spending.

When interest rate increases, consumers and investors would have less money to spend than before. As a result, consumers and investors, already saddled with debt, would have to set aside more money towards the repayment of their loans. That leaves borrowers with less disposable income to spend on their needs and wants. Therefore, consumers and investors would buy less goods and services and the companies, which provide goods and services, make less money. When profits shrinks, the price of a listed company’s stocks would inevitably dip, and that causes a drag on the stock market.

Direct effect

Companies which are already borrowing money from financial institutions would also have to bear the brunt from an increased cost of borrowing as a result of an interest rate hike. Companies would have to pay more to service their debts, leaving less money, as profits.

When interest rate is hiked, investors, who invest in the stock market on credit (margin), would soon find themselves having to close their positions, as any potential profits are offset by higher cost of borrowing. Hence, the stock market is subjected to selling pressures which would usher a slump in the market.

Conclusion

Any adjustment in interest rates, especially by the Feds, may have an impact on your equity portfolio. Being able to discern how the market would react to interest rate adjustments may give you an advantage, to either enter or exit the market. However, if you are investing in the long run, pay very little heed to any adjustments of interest rate.

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